Wednesday, September 26, 2012

Red Flags in the Analysis of Income Statements

Financial analysis is a complex and broad topic, so much so that books have been written solely on the subject. In this post, I highlight sample red flags that can be identified on an income statement. Attorneys often don’t need to understand all of the issues or answers when it comes to financial analysis of income statements; rather, they need to know how to identify red flags and what questions can be used to obtain additional information.

Red flags highlight potential areas of concern. Asking the right questions will provide valuable information about a business. Some red flags will be readily explained, while others may be indicative of business problems including the potential for errors, omissions and fraud. Developing the ability to know when to ask questions is an important skill when working with financial data.

The financial data of a business includes the financial statements (i.e., balance sheet, income statement, statement of cash flows and statement of owner’s equity). In addition, transaction-level data will be maintained in subsidiary ledgers and journals. The income statement shows the operational results of a business (i.e., the revenues, expenses and profits of a business).

One of the primary categories of the income statement is revenue. Comparing the revenue for multiple periods and analyzing the changes in those revenue figures provides information about a business’ growth. A red flag identified through this analysis is a declining revenue trend. If a business has a declining revenue trend, questions you may want to investigate include:

• What caused the declining revenue?

• Is there a valid reason for the decline (i.e., loss of a product line) or could it be an indicator of other problems?

• Does the business have a plan to address the revenue decline?

• Will the business be able to pay its bills?

• Is the business viable?

Another red flag related to the income statement is unexplained business performance, which can exist with revenues, expenses or profits that are outside the norm. When looking for unexpected performance, consider changes from prior periods, deviations from budget and performance out of sync with the business’ market and/or industry. For example, if the business’ revenues for the last several years were relatively flat (i.e., minimal or no growth) and in the current year there is significant growth, questions you may want to ask include:

• What caused the increased revenue growth?

• Is the growth sustainable or is this a one-time event?

• Why did the business have relatively flat growth historically?

Finally, large, unusual or nonrecurring items on the income statement are a red flag. Comparing the income statements of a business for multiple periods will assist in identifying these types of items. Crucial questions to ask include:

• What occurred?

• How did and will the event impact the overall performance of the business?

For example, a company may sell off a division that can have a positive impact on the profits in the current year, but in the long term it may or may not be beneficial.

When analyzing financial data, identify trends and changes in performance and ask questions about your findings to further understand what these trends and changes mean to a business. The goal is to learn about the business and how these trends and changes will impact it now and in the future.

Colleen S. Vallen is a partner in Citrin Cooperman Philadelphia’s valuation and forensic services group. An expert in the field of forensic and investigative accounting, she focuses her attention on forensic and fraud investigations, the preparation of financial damage analysis and litigation support. She is also highly experienced in the analysis, investigation and review of financial documents as well as case planning and management, financial and economic analysis, expert report preparation, oral presentation of findings and assistance with discovery, interrogatories and depositions. She can be reached at cvallen@citrincooperman.com or 215-545-4800.